Australia's banks have lost their way. We need to rethink how to regulate them

Australia’s banks are failing to meet their public obligations to drive growth and raise community welfare. This is a long-term problem. Public confidence in Australia’s banks has steadily eroded since financial deregulation in 1983. The brand of the big four, especially CommBank, is now at its nadir.

What went wrong?

There is no easy fix for the short-term incentives that drive our banks. Photo: Louie Douvis

Business model

It seems Australian banks would rather earn a fast buck than support real, longer-term investments and jobs that better all Australians. Consider the loan book of major deposit-taking institutions:

About 60 per cent of new lending is for housing.

About 80 per cent of housing loans are to buy existing property.

About 60 per cent of new loans are to investors for negatively geared investments.

About 40 per cent of housing loans are interest only.

Somewhere along the line, successive governments, the Reserve Bank, the regulator and the institutions themselves forgot that banks do not exist to facilitate investors’ speculation via the use of tax-subsidised debt. Rather, banks have a broader social licence, the flip side of their regulated «public utility» sinecure and too-big-to-fail status, requiring them and their executives to always act in the national interest.

Right now, the banks’ business model is fairly simple. Make as much profit as you can and maximise short-term shareholder value, achieved through incentivising executives with outrageous bonuses while telling Australians it will trickle down to them. Banks compete on both sides of their balance sheet. They offer their depositors and bond-holders a sufficiently attractive rate of return to attract funds. They take these funds and turn each dollar into up to $7 of loans (where regulated risk weights bias investors towards existing housing assets). The banks then offer clients ancillary services (investment advice, insurance and retirement products) to clip the ticket multiple times before the customer passes «go».

Old-style banking

Historically, the business model of Australian banks was very different. It was to prioritise the efficient intermediation of capital to businesses, prioritise first-home ownership and help macroeconomic management via reaching liquidity objectives in times of crisis.

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This old-fashioned view of banking – as a provider of basic services – shares many of the characteristics as a public utility (energy, water, sewerage, etc) that all households and businesses require, where quality is hard to observe, and some sort of regulatory control is often needed to prevent the abuse of power.

The banking system that arose from Federation emerged out of the tragedy of the 1890s property bust and depression. The newly formed Commonwealth financial system emerged via a highly regulated mix of state-owned banks, building societies and mutual institutions, charged with broader development goals. The outcome was system stability, even if credit was effectively rationed. In this world, the local bank manager was the most important and trusted person in town. Bank executives were paragons of virtue, albeit a boring sober type. The lessons of that episode seem eerily pertinent to the Australian economy in 2017.

The deregulation era

When financial deregulation finally came in late 1983, no one was particularly sad to see the old regime fall. The economy was stuck in a low productivity slump, hiding behind tariff walls. Some form of deregulation was necessary, but broader development goals were soon forgotten.

The industry was handed over to the «money changers». While the housing-loan book became the main game, it became useful to play up ancillary services more directly. Vertical integration became a deliberate strategy to move the oligopolistic competition in loans, up and down the household value stream – that is, into the payments system (credit cards), risk (life insurance and CCI) and funds management (superannuation and trading). And where supply networks are captured (mortgage brokers, branch networks, financial advice), a sales culture dominates, flogging product regardless of customers’ underlying needs.

Bank executives have apparently revelled in raising short-term shareholder value while maximising their own compensation.

In this world, the local bank branch became a shopfront with anonymous staff. Bank executives were more like highly paid celebrities.

The executives have apparently revelled in raising short-term shareholder value while maximising their own compensation. They have become oblivious to any notion of stewardship to their frontline employees, much less the community.

Bank shareholders have mostly had a wonderful run but may yet regret the lack of oversight of current and past managers. The major banks’ diverse nature throws up internal efficiency issues. These banks are bureaucratic, slow, cumbersome, and have poor internal information and systems. They are rife with infighting over internal targets and staff-performance measures, which leads to dysfunctional decision-making – for example, limits on cash deposits on smart ATM machines, plus a poor anti-money-laundering control framework.

This «incentives»-driven mentality has also exacerbated Australia’s boom-bust property cycle and addiction to debt. Household debt-to-income ratios rose from 20 per cent in the early 1980s to 130 per cent before the global financial crisis. Since the crisis, Australia’s household debt-to-GDP ratio has reached a record 190 per cent – much higher than the United States’ before the subprime crisis.

Risk of instability

Significant pockets of mortgage stress now exist all over the suburbs of Australian capital cities. Many households are servicing loans greater than six times their annual income. ME Bank reports that 9 per cent of all households think they won’t ‘t meet minimum payments on their debt over the next six to 12 months.

Since the global financial crisis, Australian banks have aided the build-up of private debt by investors chasing yield and short-term capital gains, or «making money with money» in the face of ultra-low interest rates. Banks have profited at every step throughout the latest upswing in the property market since 2013, so much so that the regulator is still struggling to dampen activity. It now seems the average yield on Melbourne residential property has fallen to 2.6 per cent, which represents a price-to-earnings ratio of 38. This is insane compared to the average ASX 200 investment, which is like 15.

Thomas Edison said genius is 1 per cent inspiration, 99 per cent perspiration. Now, thanks to Australia’s banks, it’s more like 100 per cent tax-leveraged speculation.

Is foreign competition the answer?

Former treasurer Peter Costello wants to open up the «cocooned» banking «quadrapoly» and other sheltered-workshop sectors: «Whether you split [them] up or encourage new entrants, I think we need more competition in the banking system,» he says.

So when does more competition work for customers?

Real competition creates alternatives – or meaningful choices – that put power in the hands of consumers and hence allow prices to adjust, through market forces, to reflect value for money.

But efforts to blindly implement competition when the wrong preconditions are in place leads to bad outcomes. It’s almost certain that, in those situations, the market would provide the chimera of choice via product line proliferation. Consumers will be chiselled rather than resources allocated efficiently.

Most industries in Australia lay somewhere between «perfectly competitive» fresh-fruit-and-vegetable markets and natural monopolys, like electricity transmission with its huge fixed costs. In most markets, consumers lack information and expertise, and are limited by a myriad of cognitive shortcomings.

Most of us know how to achieve value for money when buying most smaller consumable goods. But buying major capital goods and services like gas, electricity and phone contracts, health and life insurance, tertiary training and certain specialised medical care is often a completely incomprehensible challenge. Indeed, most of us probably fly blind through the most important decisions of our lives, and don’t even know it.

Alan Kohler, from The Constant Investor, says competition is especially bad when there is too much variety and choice in a service that is paid for now but delivered in decades, such as in super. In these circumstances, more information and competition doesn’t help humans with limited brain power select between product options.

Bad decisions can be life-altering. For example, choices between life-insurance policies, health funds, retirement-income products, tertiary-education courses or institutions, when and where to buy a house and how much money to spend on it.

Into the muddy field of uncertainty tred commission-driven salespeople, like snakes in long grass, who sing the praises of competition and choice. Meanwhile, they push ever more product on uninformed and confused buyers.

Is the answer more products?

Most consumer-facing industries in Australia are now dominated by two to four main competitors. Many offer a bewildering array of complex, confusing and ever-changing products, pricing schemes and/or plans, and always watchful of competitors.

So when does competition and choice benefit or harm consumers?

Competition is good when customers want bespoke goods and are best placed to exercise that choice for themselves.

Competition is bad when customers only want a basic product and perhaps can’t identify that choice for themselves.

From home loans to telephone contracts to super products to power providers – most basic customer requirements would be better met by a more «wholesale» market structure and streamlined product line. For example, all electricity retailers buy from the same place and send electrons down a wire; the product can’t be differentiated physically. So like Costco and Aldi, let’s cut out the middleman.

Regulating the banks

Reserve Bank governor Phillip Lowe says: «Banking, historically, has been a profession: a profession of stewardship, custodians, service, advisory, counsellor. It is not a marketing or product-distribution business; banking is a profession.»

Australian Prudential Regulation Authority chairman Greg Medcraft and Lowe both talk up a culture problem. But is there one? Or are we making culture a proxy for that old-time concept of stewardship that existed in a more regulated environment, where a bank-based financial system was more intrinsically linked to sourcing capital for productive allocation?

Certainly, Australia authorities must deal with structural issues in foundation financial institutions, such as monopoly, economic rents, cross-subsidisation between industry segments and daily examples of corporate criminality, with the money-laundering scandal at CommBank being the last straw. Authorities must break the hold of connected dealer groups or advisory networks on relevant market shares. The priority must be to clean up the mess and refocus the sector on core functions, at least by structurally separating various business lines.

A bold policy would be to establish a not-for-profit (public or mutual) bank, which provided home loans on a cost-recovery basis, passing the benefits of scale on to the community. For example, Nick Gruen’s idea of a «people’s bank» morphs the post office into a retail banking provider to anchor pricing. This model may point the way forward for the rest of the sector – culturally and in its business model.

Economic management lessons

Perhaps it’s already too late to avoid a hard landing. New house sales in some international capitals are falling fast as they are here. Elvis (or Asian investors) has left the building. Interest-rate increases in the US and elsewhere are likely to raise the wholesale cost of funds for our banks by 100 basis points or more by mid-2018, even if low inflation discourages the RBA from lifting rates in the near term. Prices for oversupplied market segments such as new units could take a big tumble, especially in Melbourne, further exposing highly indebted households.

The Australian economy is stuck in a downward spiral of falling competitiveness and lower productivity, in part because most Australian governments have not achieved a major microeconomic reform since Humphry B. Bear was last on television. But some aspects of past regulatory changes are also now strangling growth.

The good news is that Treasurer Scott Morrison seems to appreciate that the ultimate goal of policy should be the community’s welfare. There is no one-size-fits-all solution to competition policy and regulation; approaches should vary depending on the character of the commodity market in question.

The lesson of the last decade is to build consensus by avoiding faith-based policy and refocusing on the national interest by applying microeconomic reforms that grow incomes and create jobs.